When investing in REITs, many investors choose to focus on historical price gains, history of dividend increases, payout ratios and the like to inform their decisions. Although, these metrics can be useful starting points, relying purely on these can be outright dangerous. There is the usual problem of investing using the rear view mirror, and the more dangerous issue that if one uses fantastic past returns to justify an expectation of future returns, then chances are that the market price of the REIT in question reflects undue optimism.
Of course, such comments apply to investing in any security. Regardless, REITs in the end are fundamentally about real estate, and pretty much the only rational way to consistently generate decent returns from real estate is:
- Buy below net asset value/replacement cost.
- Sell at an acceptable premium, collecting rent in the meantime.
Certainly, holding real estate via a REIT has some additional complications. I will discuss these later.
It is hard to dispute that capital is currently quite abundant and cheap. Many, if not most, REITs trade at valuations approaching the absurd. Regardless, there are some pockets of sanity.
Lexington Realty Trust
Lexington Realty Trust (NYSE:LXP) is an internally managed net lease REIT that owns a relatively diversified portfolio of properties:
- 50% office
- 30% industrial
- 14% infrastructure/land
Note: The last number is not adjusted for the recent sale announced here.
The company's rental base is well diversified by tenant, geography as well as industry. Moreover, lease expirations are also well staggered. Consequently, rents can be considered to be recurring with a relatively high degree of conviction. These aspects of LXP have been covered in sufficient detail by Brad Thomas (for instance, see this article).
The purpose of the current note is to estimate net asset value (NAV) for LXP and compare it with its market price. The most naive way to do this is to simply take the price paid by the company to purchase its portfolio of real estate and subtract the company's debt obligations. For LXP, the relevant numbers (from the latest 10-Q) are:
- Real estate at cost: $4.5 billion.
- Debt: $2 billion.
Note: I am doing some rounding here. Since NAV is a rough concept anyway, there is little to be gained by finer precision.
This yields our first approximation to NAV of about $2.5 billion. Apply a 20% "margin of safety" haircut to get NAV of about $2 billion.
Of course, this approximation can be problematic for several reasons. The primary one being that the real estate at cost may not reflect its value in ordinary markets (management may have overpaid, underpaid, older real estate may be more valuable now, or decrepit and less valuable now, etc.).
Consequently, we at least need a sanity check.
NAV and Cap rates
As with any asset, ultimately, the value of real estate is determined by its cash flow stream. A common short cut that avoids the arithmetic of spreadsheets and discounted cash flows is to estimate the cash income (after maintenance costs) from the real estate and apply a multiple based on a suitable cap rate (i.e., the "coupon" one demands from the real estate, at least initially.
For 2015, LXP generated cash from operations of about $240 million after paying interest of about $80 million. So the real estate portfolio generated about $320 million (after administrative costs, but before interest and maintenance). Since, the portfolio mainly consists of net lease properties, maintenance responsibilities for LXP are minimal. Regardless, let's assume a $30 million maintenance charge (for comparison, LXP had capital expenditures, which includes development, build to lease, etc., of about $30 million).
Depending on location, property type, etc., commercial real estate tends to command cap rates in the 5%-8% range. For comparison, LXP has been selling properties in its portfolio in the range 3.6%-7.4% since 2011 (see this).
One important caveat to note here: In determining the cash flow from a property, many investors exclude corporate level administrative costs. This can significantly affect the valuation exercise. As very few organizations explicitly reveal the assumptions going into their calculation of "cash flow from the property," some care needs to be exercised in taking cap rates as gospel.
To belabor the obvious, lower cap rates mean the property is more valuable. Since investors should demand appropriate margins of safety, in my opinion, an 8.3% initial cap rate, using the ad hoc definition for cash flow above, is reasonable and conservative in valuing LXP's portfolio.
Putting all of this together yields a conservative value of about $3.5 billion for LXP's real estate. Subtracting debt yields NAV of about $1.5 billion.
Thus, a conservative estimate of LXP's NAV is roughly $1.5-$2 billion. As of writing, the market capitalization of the company is $2.3 billion. Certainly, there was a significant margin of safety in LXP a few months back when the price was about 20%-30% lower. However, the current price is still quite reasonable.
Of course, since we are looking at real estate via the proxy of a publicly traded REIT, there are some additional considerations. The primary ones being LXP's capital structure and the competence of management. As far as capital structure goes, the company is no better and no worse than the average REIT primarily fixed rate long-term debt with staggered maturities (note: this is a drastic improvement from some years ago), decent interest coverage, etc.
Management competence-wise too LXP is no better and no worse than the average REIT. Management did make missteps in the past, but thankfully, in recent times, they have been correcting these, they have not been issuing any significant equity at depressed prices just for the sake of growing, etc.
At current prices, this is not an investment to bet the farm on, but certainly deserves a spot in a well-diversified basket.
Disclosure: I am/we are long LXP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.